Churchouse Letter
July 2014               by Peter Churchouse

Debt Soundings

Alarm bells are starting to ring in the media about the large amount of debt that has been building up in Asia over the past few years.

China in particular has seen an unprecedented explosion in bank lending, household debt in South Korea and Taiwan in particular continue to move higher and overall credit in Hong Kong, Thailand, Malaysia and Singapore is growing, furrowing the brows of market watchers everywhere.

There is no shortage of alarmism about Asian debt growth right now. We wrote about it in our November 2013 AHA Report "Asia on the Brink Again?".

We think there are clearly some sustainability problems with debt growth in China in particular, especially in the heavy industry and property development sector. We will see defaults, restructurings and mergers/acquisitions in the future for sure.

However, I believe that many are building a debt mountain out of a molehill, and the nervous reports of an impending Asian credit crisis have been greatly exaggerated.

Which is exactly why I want to find buying opportunities as these debt driven fears drive developers’ stocks downwards.

Property companies have particular problems when it comes to debt. They have large sunk costs in each development they build, and if a developer needs to raise cash in a hurry, their product isn’t always easy to sell for a tidy profit.

When the market is moving in their favour, all is well and good for property companies. When the market turns, those with heavy debt loads struggle to carry that burden.

We’re here to find the Asian property companies that can carry those debt burdens through the hard times, and come out swinging on the other side.

In this edition of the AHA Report you get:

  • An analysis of the debt profiles of larger property companies in Asia (Hong Kong, Singapore, Australia, Japan, China and ASEAN).
  • An explanation of the methodology to our madness: current ratios, quick ratios and cash ratios.
  • A rundown on the importance of managing property, not just developing it.

Our 3 Asian property picks that will propser when times are good, and offer downside protection if the market sells off.

Enjoy the issue,

Peter


Inside This Issue:
Worries about the rapid growth of debt in Asia are becoming more pronounced.
There are certainly areas for concern, but it’s wrong to put all companies and countries in the same box.
We believe there are some great opportunities to buy safe income-generating stocks at good prices.

My first lesson about borrowing is something that I remember well. I was working as a consultant with a mid-sized Hong Kong developer, and it was increasingly clear that his eyes were bigger than his bank statement.

He was leveraged to the hilt. At one of our sessions, I suggested that property prices were poised for some downside. “Why?” he asked.

My numbers showed that only about 5 percent of Hong Kong households could realistically afford to service a modest mortgage on even the cheapest entry-level property. The affordability index was as far out of whack as I had seen to that point – or since.

I had the temerity to suggest that property prices might turn down by 10 to 15 percent. “Nonsense,” he argued. “Peter, what do you know about us Chinese? You have only been here nine months.You don’t know how we Chinese think and behave.”

I held my counsel. I was wrong. The property market did not fall 15 percent. It fell 70 percent over the next three years.My client disappeared under a mountain of debt and has never sur-faced again.

Excess debt, greed, arrogance, and simply ignoring the facts led to his corporate demise. He had little to no recurring income, and masses of debt sunk into new projects. They weren’t going to sell quickly as interest rates rose and the bubble popped. He certainly didn’t have enough recurrent income to service the interest pay-ments on his debt pile.

“Can Asia overcome its addiction to debt?”

That was the opening sentence of a May article in the Financial Times.

The rating agency Standard & Poor’s estimates that Asia’s non-bank corporate debt was US$24.2 trillion at the end of 2013, compared with US$14.1 trillion in North America and US$11.2 trillion in Europe.

The alarm bells are ringing. China is about to collapse under the weight of its own debt. The Asian miracle is over.

There is no shortage of alarmism about the build-up of debt in the Asia region. We have written about this recently (see the Asia Hard Assets Report Edition 43, November 2013, “Asia on the Brink Again?”).

I’ve said it before and I’ll say it again: The alarmists are wrong.

Now, I’m no apologist, and Asia still leaves a lot to be desired. But it is simply wrong to tar all countries with the same brush. And it is equally wrong to treat all Asian companies the same.

Most of the major hard-asset property companies in Asia are not at huge risk from their debts. Now there are clear problems in China, particularly in steel and heavy industry, and there’s no doubt some Chinese property developers are going to go under. Since 2008 Chinese Corporate debt in particular has grown at lev-els which are simply unsustainable.

However I am looking for buying opportunities as these debt-driven fears drive stocks south. I believe most of these fears will ultimately not materialise. More importantly even if they do, we are looking for companies that will weather the storm.

Debt at the Centre of Most Financial Meltdowns

Pretty much every major recession, regional or global financial crisis has excess debt at its base. At the core of the debt mountain is massive lending to hard assets; first and foremost real estate, but sometimes also infra-structure and commodities.

Try to think of any financial crisis in modern history that has not been accompanied by rapidly rising real estate.

Take the GFC. Rapidly rising real-estate prices and excess building in many parts of the Western world. I am not saying that real estate bubbles caused these financial crises. Correlation alone does not prove causation. In most cases, you can also fault the behaviour of central banks, commercial banks, regulators and government policy makers.

But I have been worrying about something for some time.

What really scares me is that the massive money printing by central banks around the world is basically going to bring us back to the point that we reached in 2008. It’s also the same place that Asia found itself in 1997/98. We may not have to wait another four years, to 2018, for it to happen again.

Central banks and governments are desperate to encourage you, me, and businesses everywhere to take on more debt.

You can see why. To them more debt means more consumption, more employment, more houses, factories and offices built. All to boost economic growth.

Asian economies were the first to recover from the 2008 meltdown. They were the first to see a sharp re-covery in real-estate prices. It happened so fast that the word “bubble” was uttered here very quickly after the GFC. Now people are worrying about the same thing in many Western markets such as the United Kingdom, parts of the United States, Canada, Australia and New Zealand.

There is also no question that debt in Asia has risen sharply, both in absolute terms and in relative terms, as a percentage of gross domestic product... Especially in the corporate and household sectors.

In this edition of the Asia Hard Assets Report, we are sounding the debt depths of the larger hard-asset companies in Asian real estate.

Why should we care? Well, there are a couple of rea-sons. Asian real-estate stocks make up the lion’s share of the global real-estate sector by total market capitali-sation. Second, if Asia falls into a debt-induced funk, there is a good chance that this cycle will not just be limited to Asia. The contagion is likely to infect the West, where the economic health is already shaky and debt is rising rapidly once again.

We want to help you find companies that prosper in this environment, and withstand market turmoil.

Where does debt go? Basically, it moves towards the development and ownership of real estate of one kind or another.

So we are looking at the core debt characteristics of major regional property companies. Real-estate devel-opment and ownership is capital intensive and long term. Debt funding is central to the entire business. It can take years to develop sites for sale or for invest-ment. Between buying the land and developing it, a lot can change.

Carrying large amounts of debt for a long time, for assets that have a long gestation period (i.e. take a long time in the making) can be highly risky.

To get a feel for credit and liquidity risk for property companies in Asia, we looked at total debt, both long-term and short-term, relative to the value of a company’s assets. We want to exam-ine the ability of companies to repay short-term debt in particular.

We are trying to determine a company’s vulnerability to adverse events, both commercial and financial. The ability to roll loans over is not a given – unless perhaps you’re in China!

We take a look here at the net debt-to-equity ratio, also called net gearing. Forgive me for getting technical, but I’ll give a little of the methodology behind our findings.

The net debt to equity ratio is defined as: all short and long term debt (minus cash), divided by the book value of equity.

Note that the term “net debt” differs to “total debt” because it takes away a company’s cash holdings.

Book value” is simply the value of a company’s assets that shareholders would receive if it were liqui-dated.

In simplistic terms, the lower the ratio, the lower the risk.

For property companies, the “equity” is basically land, properties under construction, completed proper-ties held by the company and retained earnings (Note: Retained earnings are simply what a company retains from net earnings that’s not paid out as dividends, usu-ally marked for reinvestment or paying debt for exam-ple). In normal accounting, land and property under construction are both held in the accounts at cost. It’s what was paid for the land, and how much has been spent so far on construction.

Investment properties, or unsold completed proper-ties, are normally held in the accounts at the current market value, usually determined by external assessors. Obviously, this can go up and down reflecting property cycles.

Generally speaking, a lower ratio means there is a lower risk of default on loans.

There is no ideal ratio for property companies. For example, many large Japanese property companies have net debt /equity ratios well north of 1. And they have survived like this for many years. On the other hand, companies in Australia with those kinds of ratios went under back in 2008 and 2009, as did many companies in the late 1980s in the US.



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